Option Pools and VC Negotiations

In my last post about raising seed vs. jumping straight to A, I received a good comment from Chris Woods that my analysis neglected to include the impact of option pools that are created at each financing round. It was a good point, and one that is worth touching on with a dedicated post.

In almost every financing round, there is an important stipulation in the term sheet that talks about the employee option pool that will be created in tandem with the financing. Essentially, the new investor wants there to be a certain % of options available to employees after they invest.

There have been others in the past that have detailed the math behind option pools and their impact on venture deals. Here are three good ones from Venturehacks, Mark Suster, and Jeff Bussgang. The short implications are:

You should definitely discuss this as part of your valuation/deal negotiations. It has a meaningful impact on your net dilution, and I’m often surprised how often founders don’t consider this a malleable term.

I find that VC’s will tend to propose a larger option pool than is really needed. It’s not that we are bad, it’s that we are self interested. We know that at the next financing round, the new investor will probably want to have a certain sized pool available for future employees, so if we make the pool pretty big up front, we are less likely to share in that dilution down the road

It does NOT make sense to try to change the rules of the game and get the VCs to handle this term differently than what is standard in the industry. You are better off in almost all cases maintaining the standard, but being savvy about negotiating this term.

The negotiation tactic to take is to justify the size of pool that you think is reasonable. Basically, have an estimate of the hires that you are likely to make over the course of the next round and the equity packages you are expecting. Provide even an additional factor for “opportunistic hires” in case you happen to find “the best person in the world” for role X and want to bring them on prematurely. Add it up, and ask the VC why that level of options is not sufficient. It’s hard for a VC to make a principled argument in response to this that isn’t mainly self-serving. Or, it will be a good catalyst for an important discussion with the VC that will tell you a lot about how they are perceiving the quality of your team and the types of folks you need to bring on sooner rather than later.

What is a typical size of option pools that we see in the market? This tends to vary by company, stage, and completeness of team. As a result, I think most folks are kind of hesitant to put numbers out there because they can be misconstrued. But I’m going to give some ranges based on our portfolio, as I think it gives at least directional guidance for founders.

For seed rounds, we have seen options pools in the last 12 months in the range of 5% (which is low) to 10% (which is a bit on the high side). 7.5% is a pretty decent place to be. Keep in mind that these are for rounds where a) we are NOT contemplating bringing in an outside CEO and b) we believe that there is enough technical leadership in place to take the company to a good place. As such, these numbers do not contemplate an extremely senior hire that ought to take up a large chunk of the pool on their own.

For series A’s, we have seen option pools in the last 12 months in the range of 7-15%. This means that whatever % remains unallocated, the new investor is asking for the pool to be increased to this percentage. In some cases, it’s getting the pool to more or less the same size as what we had after the seed, but sometimes more or less.

As a means for comparison, historically, first institutional financing rounds used to require option pools in the 20% range, sometimes more, rarely much less. This was more in the days prior to the popularity of institutional seed rounds. Net net, I think that currently entrepreneurs are able to manage this more effectively. It’s fairly typical for a founder to start with a pool of 7.5%, actually only allocate ~5%, and then raise their next round requiring the pool be refreshed to 10%. Thus, the actual net effect is 5+10 = 15% dilution after 2 rounds, with your seed investors sharing in your dilution when you go from seed to series A.

Ultimately though, negotiating too hard here can signal a focus on the wrong thing. Investors want to work with entrepreneurs who want to build great companies, and will attract great people to do it. You don’t want to come off as overly stingy about equity to the point that one wonders whether you will do what it takes to attract the best talent to the team. But I wouldn’t shy away from the discussion either, because it has meaningful economic impact to founders and is the basis for an important discussion with your investors about how they view team building in the coming months and years of the company.

About Me

Rob Go

Thanks for checking out my blog! Here’s a quick background on who I am:

Rob Go

Thanks for reading! Here’s a quick background on who I am:
1. My name is Rob, I live in Lexington, MA
2. I’m married and have two young daughters. My wife and I met in college at Duke University - Go Blue Devils!
3. We really love our church in Arlington, MA. It’s called Highrock and it’s a wonderful and vibrant community. Email me if you want to visit!
4. I grew up in the Philippines (ages 0-9) and Hong Kong (ages 9-17).
5. I am a cofounder of NextView Ventures, a seed stage investment firm focused on internet enabled innovation. I try to spend as much time as possible working with entrepreneurs and investing in businesses that are trying to solve important problems for everyday people.
6. The best way to reach me is by email: rob at nextviewventures dot com